Economy the Size of Portugal, Ireland, and Greece Combined is at Risk

Aug022012

After equivocating for many months, the Spanish government agreed on June 9 to a €100 billion ($122 billion) bailout of its financial sector by the European Union. The Spanish finance minister made a formal request for aid on June 25, and Eurozone finance ministers unanimously approved a memorandum of understanding on July 20. Spanish banks—particularly the regional savings banks known as “cajas”—have sustained significant losses stemming from real estate loans that soured in the wake of a bursting of the Spanish housing bubble. Those regional banks are now in need of substantial recapitalization, which is the primary reason behind the financial assistance package.

Although the majority of the rescue package’s features have been approved, the final details will not likely be finalized until September when the results of an independent audit of the Spanish banking system will be completed. The EU will directly recapitalize Spanish banks, instead of funneling the funds through the Spanish government. By taking this approach, Spain can avoid increasing its debt-to-GDP ratio by nearly 10%. Spain’s sovereign debt had been significantly lower than other Eurozone periphery countries, but it is now approaching a nearly unsustainable level. This high debt level has contributed to a recent dramatic increase Spanish borrowing costs.

Debt markets have remained turbulent in spite of the news of a Spanish financial sector bailout, as the yield on Spanish 10-year bonds jumped to a 15-year high of 6.83% in the second trading day following the program’s announcement and have since increased to a high of 7.62% (see Figure 1 below). The ongoing turmoil likely relates to the belief held by many economists and market watchers that Spain will eventually need a full Greece-style bailout in order to set its economy on a more sustainable path and calm the market for Spain’s sovereign debt.